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A charitable remainder trust allows a donor to take an income,
estate and/or gift tax charitable deduction for an amount transferred in trust,
where the income of the trust (expressed as a percentage of the trust's initial
or yearly fair market value) is paid to the donor (and/or others designated by
him) for a specified term or for life, and the remainder is paid to charity at
the end of the term. The charity's remainder interest in the trust must be
equal to at least 10% of the value of the assets placed in the trust. The amount of the deduction is limited to the
actuarial value (determined under §7520 from IRS tables) of the remainder
interest at the time of the contribution.1

There are a number of types of inter vivos and testamentary
charitable remainder trusts. The two standard variations are the charitable
remainder annuity trust (CRAT) in which the donor and/or other noncharitable
beneficiaries receive a fixed dollar amount ("sum certain"), which
may be expressed as a percentage of the initial fair market value of the
assets, and the charitable remainder unitrust (CRUT), in which the donor and/or
other noncharitable beneficiaries receive a stated percentage of the value of
the trust's assets determined annually. In either case, the stated percentage –
either initial or annual – of the value of the trust's assets that is used to
calculate the payout must be no less than 5% and no more than 50%.

Subcategories within the CRUT category include the "income
only" unitrust (or "NICRUT"), which pays the noncharitable
beneficiary the lesser of the net income of the trust (as defined in the
trust instrument, which must not be inconsistent with state law) or a fixed
percentage of the fair market value of the assets of the trust, determined
yearly, and the net-income-with-makeup charitable remainder unitrust
("NIMCRUT"), which includes an optional "make-up" provision
allowing any amount not distributed in a year in which the trust had no income
(or income that was less than the stated unitrust percentage) to be "made
up" in later years if the trust produces income in excess of the unitrust
percentage in those years. The NIMCRUT may be appropriate for unitrusts with
assets which are not readily marketable or which will produce little or no
income in the earlier years of the trust.

On February 21, 2006, Arthur Schaefer ("Decedent") created
and funded (with nonvoting LLC interests) two trusts: Arthur E. Schaefer
Charitable Remainder Unitrust Number 1 (Trust 1) and Arthur E. Schaefer
Charitable Remainder Unitrust Number 2 (Trust 2) for the benefit of his two
sons during the trusts' noncharitable terms.

The trust agreements provide for quarterly distributions to the
income beneficiaries during the "Unitrust Period" of the lesser of
the net trust accounting income for the taxable year or a percentage, equal to
11% for Trust 1 and 10% for Trust 2, of the net fair market value of the trust
assets, valued annually. At the end of the Unitrust Period the remainder of the
principal and income in each trust is to be distributed to a charitable
organization.

Decedent died in Wisconsin on March 9, 2007, a little over a year
after the trusts were established. His estate did not claim a charitable
contribution deduction for any portion of the trusts on its Form 706. Instead,
the estate reduced the amounts reported on Schedule G, Transfers During
Decedent's Life, by the amounts it deemed to be charitable.

The IRS issued a notice of deficiency, in which it explained that
the estate was not allowed a charitable contribution deduction for the values
of the remainder interests of the trusts because the trusts did not meet the
requirement that the value of the charitable remainder interest be at least 10%
of the net fair market value of the property on the date of contribution, and
the estate had not shown any other basis upon which the charitable remainder
interests in the trusts should be discounted.

After pre-trial stipulations of fact, the only remaining issue was
whether the trusts met the 10% remainder requirement. The parties agreed that the estate was not
entitled to the charitable contribution deduction if the values of the
charitable remainder interests in Trust 1 and Trust 2 were calculated on the
basis that 11% or 10%, respectively, of the net fair market value of the assets
is distributed each year. However, they also agreed that the estate was
entitled to the charitable contribution deduction if the values of the
charitable remainder interests were calculated on the basis that an amount
equal to each trust's net income, determined using the (lower) §7520 rate, was
distributed each year.

The text of §664(e), while reasonably specific on how to value a
charitable remainder interest of a standard CRUT, is, in the view of the Tax
Court, ambiguous, or silent, concerning how to value the remainder interest
under the NIMCRUT exception. Thus, the
estate argued that NIMCRUT distributions should be determined, not under the
general rule, but under an exception to this rule that would require the
remainder interest to be valued by using the §7520 rate to determine the
trust's expected income, so long as the §7520 rate is above 5% of the net fair
market value of the assets.

Given this ambiguity, the court consulted the legislative history to
§664(e), which, in the Senate report,3
"makes clear that where there is a net income provision, the distribution
amount or rate set forth in the trust instrument is to be used for valuation
purposes even though distributions may be limited by net income."4

The regulations,5 stated
the court, are less clear. The court pointed out, however, that
"[i]ndependent of the regulations," the IRS has issued administrative
guidance on the subject of valuing a remainder interest in a NIMCRUT on several
occasions.6 That administrative guidance
"asserts that the remainder interest of a NIMCRUT is valued using the
fixed percentage stated in the trust instrument, regardless of the fact that
distributions are limited to trust income," and even in Rev. Rul. 72-395,
with reference to a sample provision, explained that "notwithstanding the
*** [net income makeup provision], the computation of the charitable deduction
will be determined on the basis that the regular unitrust amount will be
distributed in each taxable year of the trust." Similarly, Rev. Proc.
2005-54 states: "For purposes of determining the amount of the charitable
contribution, the remainder interest is computed on the basis that an amount
equal to the fixed percentage unitrust amount is to be distributed each year,
without regard to the possibility that a smaller or larger amount of trust
income may be the amount distributed."

While the court noted that it is not bound by revenue rulings or
procedures, they are entitled to deference when thoroughly reasoned and
consistently adhered to over a long period of years. In this case, "the
guidance has withstood the test of time."

Conclusion.

The court determined that:With regard to the statute before
us, the legislative history and the administrative guidance point us to only
one conclusion—that the value of the remainder interest of a NIMCRUT must be
calculated using the greater of 5% or the fixed percentage stated in the trust
instrument. Accordingly, the estate must use an annual distribution amount of
11% or 10% of the net fair market value of the trust assets when valuing the
remainder interests of Trust 1 and Trust 2, respectively. Because the parties have previously
stipulated that the estate would not be entitled to a charitable contribution
deduction if the remainder interests are valued using this method, respondent's
determination denying the charitable contribution deduction is sustained.

The Schaefer trusts therefore failed the 10% test and no deduction
for the value of the remainder was allowable.

Note that most estate planning actuarial software (such as, e.g.,
NumberCruncher and Tiger Tables) assumes that the IRS's position is the correct
one in providing values for interests in charitable remainder trusts. It is
unclear, however, whether the estate in Schaefer used such software.

For more information, in the Tax Management Portfolios, see
Rosepink and Bradley, 865 T.M., Charitable Remainder Trusts and Pooled
Income Funds, and in Tax Practice
Series, see ¶6280, Charitable Deduction — Section 2055.

3 Section 664(e), which
governs valuing a remainder interest in a CRAT or a CRUT, was enacted as part
of 1969 TRA. The underlying House bill containing the provisions for CRATs and
CRUTs did not include a provision allowing for distributions to be limited to
net income. H.R. 13270, 91st Cong., §201 (1969) (as passed by the House, Aug.
7, 1969). A Senate amendment included both §664(d)(3), which allowed for
distributions to be limited to net income, and §664(e), which provided for
valuing the remainder interest of the trust.

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